Economic update – November 2010

The UK economy grew by 0.8 per cent in the third quarter of 2010, twice as fast as expected by City economists. As in the second quarter, growth was boosted by a large increase in the output of the construction sector, but manufacturing output also increased strongly and there were solid increases in output across the service sector. Growth in the last three quarters has averaged an annual rate of 3.2 per cent.

The UK economy grew by 0.8 per cent in the third quarter of 2010, twice as fast as expected by City economists. As in the second quarter, growth was boosted by a large increase in the output of the construction sector, but manufacturing output also increased strongly and there were solid increases in output across the service sector. Growth in the last three quarters has averaged an annual rate of 3.2 per cent.

This was welcome news for the Chancellor, who announced cuts in public spending totalling £81 billion by 2014/15 as a result of the government’s Spending Review. His critics have argued that the economy is too weak to cope with spending cuts on this scale and with substantial tax increases (VAT and national insurance contributions both go up in 2011).

But he can point to these growth numbers and recent large increases in employment as signs that the economy is in rude health. However, it is very unlikely that growth will be maintained at a rate in excess of 3 per cent.

Some of the recent strong performance reflects temporary factors including a return to inventory building, a modest easing of lending conditions by banks and the massive fiscal and monetary stimulus put in place by the previous government and the Bank of England. Irrespective of the effects of the new government’s fiscal policies, growth was likely to slow in 2011.

Meanwhile, one member of the Monetary Policy Committee (Adam Posen) has now voted in favour of increasing the Bank of England’s quantitative easing (QE) programme and the Governor also appears sympathetic to such a move. This is despite inflation remaining more than 1 percentage point above its target rate of 2 per cent.

If QE is increased it will be due to concerns that the economic outlook has deteriorated in recent months, something that is reflected in declining business and consumer confidence and in a weakening in the housing market.

Output growth in the third quarter beats expectations: Real GDP – the total output of the economy – increased by 0.8 per cent in the third quarter, well ahead of expectations. At this stage, the only breakdown we have is by sector and this shows that construction output surged by 4.0 per cent, while there was also a 1.0 per cent increase in manufacturing output.

These two sectors, together with business services and finance have been the strongest areas of the economy in recent quarters – and they were also the weakest in the recession. While there are reasons to believe that growth will not be maintained at its recent pace, for now optimists on the economy will rightly point to these numbers in support of their case.

See Figure 1:

Retail sales contract for the second month in a row: The volume of retail sales fell by 0.2 per cent in September, having already contracted by 0.7 per cent in August. These falls coincide with a drop in consumer confidence and with renewed weakness in the housing market (see below). This might be attributed, at least in part, to worries about the effect of the government’s budget, announced in June.

It would be natural to assume that talk of austerity and the prospect of swingeing spending cuts and an increase in VAT and national insurance contributions in 2011 would lead to increased caution on the part of consumers.

The surge in employment is maintained: There was a 178,000 increase in employment in the UK between March-May and June-August (down from the record 288,000 increase recorded a month ago). Part-time employment continues to increase at a rapid pace. Indeed, the 143,000 increase over the last quarter was the highest on record.

However, there are now 1,140,000 people working part-time who say they are doing so because they cannot find a full-time job. This is also a record.

Narrow concentration of job creation: The latest data on jobs by industry are for June show a 71,000 increase in the number of jobs, compared to March. This job creation was concentrated in two sectors. The number of jobs in construction increased by 53,000, which is consistent with the GDP data showing a surge in output in the sector, and the number of jobs in agriculture, forestry and fishing increased by 32,000, which looks to be a blip in the data because it is equivalent to a 7.6 per cent rise.

Manufacturing employment continued to fall and there was a mixed picture across the service sectors, with some showing modest growth and others a small contraction in the number of jobs.

A possible change in trend in unemployment: The Labour Force Survey (LFS) is still suggesting unemployment is falling, by 20,000 between March-May and June-August, but the claimant count measure increased for the second consecutive month in September, by 5,300. This could be an early sign of the effect of cuts in employment in the public sector.

The housing market has weakened: There is accumulating evidence that the housing market has weakened since the beginning of the summer. Mortgage lending is growing at an anaemic pace and the number of mortgage approvals in September, although only a little lower than the average in the first eight months of the year, was down 15 per cent compared to September 2009.

Meanwhile the Halifax reported a 3.6 per cent fall in prices in September and the Nationwide reported prices had fallen in three out of the last four months up to October.

Price inflation was unchanged in September: Consumer price inflation remained at 3.1 per cent for the third consecutive month in September. A sharp fall in transport prices was offset by higher prices for clothing and footwear.

The Bank of England will be publishing its latest inflation forecast later this month. It is likely to show inflation remaining above its target rate of 2 per cent throughout 2011, in part due to the increase in VAT scheduled for January. Meanwhile, average earnings are increasing at an underlying rate of 2 per cent, suggesting that real purchasing power is still being squeezed.

See Figure 2:

Government borrowing is turning out a little lower than last year: Public sector net borrowing (excluding the temporary effects of financial interventions) was £16.2 billion in September. After six months of the 2010/11 fiscal year it totalled £73.5 billion, compared to £77.4 billion in the same period of 2009/10.

Export are booming – but so are imports: Export volumes in the first eight months of the year were 10.4 per cent higher than in the same months of 2009 – but import volumes increased by 11.0 per cent over the same period. Consequently, the trade deficit is gradually widening.

The Office for Budget Responsibility hopes that net exports (the difference between export and import growth) will boost economic activity in the UK over the next few years. If they are wrong, it may be because import growth remains strong, rather than due to a failure on the part of exporters.

See Figure 3:

Interest rates remain at 0.5%; QE at £200 billion: The Monetary Policy Committee left interest rates at 0.5% and the amount of quantitative easing at £200 billion in October. One member voted to increase the Bank Rate from 0.5% to 0.75%, but another voted to increase QE by a further £50 billion.